Potential Costs of Asset Purchases

The Trading Desk at the New York Fed implements monetary policy on behalf of the Federal Open Market Committee (FOMC). Primary dealers are select banks and securities broker-dealers that trade U.S. government and select other securities with the New York Fed; they are trading counterparties in the implementation of monetary policy.

The primary dealers are surveyed prior to each FOMC meeting, and the survey results help the FOMC evaluate market expectations about economic, financial, and monetary developments. The questions on the survey change to reflect topics discussed in FOMC statements, meeting minutes, and FOMC member speeches. The January 2013 survey included the following question:

The minutes of the December FOMC meeting stated that while almost all members viewed the asset purchase program begun in September as having been effective and supportive of growth, they also generally saw that, "The potential costs could rise as the size of the balance sheet increased." Please rate the potential costs cited according to your current assessment of their importance in determining the size, pace, and composition of asset purchases going forward. (5 = very important, 1 = not important).

Here's a tabulation of the results from 21 primary dealers, provided by the New York Fed:

Most of the dealers rate an increase in inflation expectations as a low to medium risk of the Fed's asset purchases. In a speech on March 27, Eric Rosengren of the Boston Fed noted that "Most of the original critics of LSAPs voiced concerns over the potential impact on inflation and inflation expectations. However, the expansion of the Federal Reserve’s balance sheet began in 2008 and five years later we currently have a PCE inflation rate of 1.2 percent, well below our 2 percent target. As the years have passed and inflation has remained stable, this criticism has become more muted."

The second potential cost is "impairment of future implementation of monetary policy." Most of the dealers are at least moderately concerned about this, with 10 rating it at 4 or 5.  Sandra Pianalto of the Cleveland Fed expressed this concern in her speech, also on March 27, saying that "should inflationary pressures emerge, there is the risk that the Federal Reserve's ability to respond could be complicated by the size and composition of our balance sheet. We have developed tools to remove monetary policy accommodation when the time comes to do so, and we have even tested them on a small scale, so that we will be ready to use them. We have planned carefully, but we are in uncharted territory."

Most seem to agree that the effect on Federal Reserve net income is not an important cost of the asset purchases. There is moderate to high concern about effects on market functioning. Simon Potter, Executive Vice President of the New York Fed, explains this concern and how the Fed is addressing it:

There is a finite supply of Treasury securities and agency MBS available to purchase, in terms of both total outstanding amount and how much is available for purchase in the market at any given time. If the Federal Reserve were to become too dominant a buyer or holder, it could reduce the tradable supply of these securities and discourage trading among market participants, leading to diminished liquidity and price discovery. A significant deterioration in liquidity could lead investors to demand a premium for transacting in these markets, ultimately raising borrowing costs and undermining the program’s policy goal. 

With this concern in mind, the Desk closely monitors how our implementation of asset purchases impacts financial market functioning. In particular, we follow measures of market activity, such as trading volumes, bid-ask spreads, trade sizes, quote sizes, financing costs, and settlement fails, as well as other indicators. We also monitor indicators related to our operations, which can provide some direct insight into potential market functioning issues. These include the prices at which we can execute in comparison with prevailing market quotes, the extent and concentration of dealer participation in operations, and the ease of settlement of our MBS purchases... Based on these types of measures, our operations are going smoothly and market liquidity is holding up well. 

In addition to this monitoring, we have developed active policies to help prevent market dysfunction as a result of our operations. In the Treasury market, the Desk ceases purchases of a specific security once SOMA holdings of that security reach 70 percent of the outstanding stock. In addition, when SOMA holdings of a specific issue exceed 30 percent of outstanding securities, the Desk limits the rate at which it acquires new holdings of that issue based on a predetermined, graduated schedule.

Potential costs to financial stability are also seen as fairly important by the dealers, although a substantial minority (6 out of 21) rate this problem as just a 2. Fed officials are also divided on this issue. Rosengren expressed the less-worried position:

Some observers have noted that stock prices have risen quite substantially...Make no mistake, this would pose a financial stability problem if stock prices had significantly outstripped likely earnings – particularly if those investing in stocks had become highly leveraged and were particularly susceptible to a reversal in share prices... While share prices have risen, so have operating earnings. And while there has been some increase in the ratio, it remains well below the 20-year average. 

Other observers have noted that residential real estate prices have risen significantly in some markets, and that this could pose a financial stability problem. Since homes are normally purchased with significant debt, a rapid increase in prices could risk a repeat of the problems of the past decade...While housing prices have risen in many markets recently, they remain well below their peak prices. Furthermore, if one compares an index of house prices to a rent index (shown in Figure 6), assessing whether the values of homes are approximately in line with the services that housing provides, as reflected in rental rates, house prices have now fallen enough that this ratio is back to where it was in 1993, well before the run-up in house prices. 

Another area of potential concern has been the increase in high-yield bond issuance... Firms with high-yield bonds are refinancing those bonds, much like many homeowners have refinanced their houses. This refinancing improves the cash flow of companies and makes them more able to weather shocks. However, if these yields are low because investors are bidding aggressively for such bonds, reaching or over-reaching for higher yields in a low interest rate environment, then one would expect to see high-yield bond rates fall more than relatively safe rates, reflecting the strong desire to take on more of this debt at lower yields, despite its higher risk....The spread between high-yield bonds and 10-year Treasury securities is currently a little below the average spread over nearly two decades.That means that high-yield rates have fallen approximately in line with the rates on safe assets, implying stable rather than significantly diminished compensation for risk.

Last week, the Fed decided to continue its $85 billion per month of asset purchases. Charles Evans of the Chicago Fed said that "At the moment, it is not even a close call" that the benefits of continuing the asset purchases outweigh the costs.

Wealth and Motivations for Saving

In a recent column in the Atlantic called "Building the Wealth of the Poor and Middle Class," Noah Smith suggests a few ways to improve the unequal distribution of wealth in America. He notes that "one obvious thing we could do to make wealth more equal is - surprise! -redistribution...Giving the poor and middle-class more income will boost the amount they are able to save, the percentage they are willing to save, and the return they get on those savings. Part of the reason America's wealth distribution is so unequal in the first place is that our income distribution is very unequal." But he adds (emphasis added):

There are reasons to believe that redistribution can't fix all of the problem, or even most of it. If you do the math, you discover that in the long run, income levels and initial wealth...are not the main determinants of wealth. They are dwarfed by...savings rates and rates of return. The most potent way to get more wealth to the poor and middle-class is to get these people to save more of their income, and to invest in assets with higher average rates of return...In addition to "nudging" middle-class and poor Americans to save more, we can help them get a better return on their assets -- the second thing that has a huge effect on wealth in the long run.

I think there is good reason to believe that a lot of people don't understand the importance of getting a good return on their assets. I am working with the Dutch National Bank Household Survey data in my research, and some of the survey questions have to do with motivations for saving. About 2000 households take the survey. In one question they are asked  to rate how important it is "To save so that I generate income from interests or dividends" on a scale from 1 to 7, with 1 being "very unimportant" and 7 being "very important." They can also choose "not applicable."

In 2012, the most common response to this question was 1, that is, that generating return is a very unimportant consideration in household's saving behavior. Two other questions ask how important it is to save "so that I have some extra money to spend when I'm retired" and "to cover unforeseen expenses." The most common answer to both of these questions was 6, with most respondents choosing 5, 6, or 7. In short, even though most respondents understand some reasons for saving, they do not see much importance of saving to earn interests or dividends. This data is from Dutch households, but American households are probably similar: many people likely do not realize the power of compound interest or understand how getting a good return on assets has a huge impact on wealth in the long run.

In the chart below, I plot responses to the question about the importance of saving to generate income from interests or dividends in 2012, grouped by people without and with a university education. The university-educated group rates this as somewhat more important. Respondents are also asked to self-report their level of financial knowledge. In the second graph I plot the fraction of people who respond 5, 6, or 7 by self-reported financial knowledge. Only 16% of people who say they are "not knowledgeable" think that saving to generate income from interests or dividends is important or very important, compared to 39% of "very knowledgeable" people.

I think this lends some support, however tentative, to Noah Smith's proposal to teach the public more about how wealth builds over time and why it is important to get a good rate of return. If people don't really grasp the importance of earning interest, then they are not very likely to make an effort to get a good return, which doesn't bode well for their future wealth. And knowledge does seem to help.

Cyprus Levy: Historical Precedents

In 1991, in response to considerable debt management concerns among European nations, Barry Eichengreen wrote a paper called "The Capital Levy in Theory and Practice." A capital levy on wealth-holders with the goal of retiring public debt was perhaps the most controversial proposed solution to the European public debt problem. Eichengreen provides a theoretical framework for considering the effects of such a levy, a list of challenges to successful implementation, a "catalog of failed levies," and an example of an exceptionally successful levy. Eichengreen's framework and lessons from history are useful for considering the levy on savings in Cyprus that is planned as part of Cyprus' 10 billion euro bailout.

Eichengreen's model uses insights from the literature on time consistency and government reputation. If governments could commit to only issuing capital levies under certain circumstances (in technical terms, if capital taxation is a state-contingent claim with full commitment mechanism), then governments could optimally issue levies when government obligations are unusually high, social returns to spending are unusually high, and/or conventional revenues are unusually low. "If the contingencies in response to which the levy is imposed are fully anticipated, independently verifiable, and not under government control," he writes, "then saving and investment should not fall following the imposition of the levy, nor should the government find it more difficult to raise revenues subsequently."

Of course, there are major practical impediments  First, full government commitment technology does not exist. If a government were to precommit to a plan for how its capital taxes would respond to future contingencies, it would end up having an incentive to renege on its commitment. Knowing this, savers would shift their capital to tax havens. Reputational concerns can partially get around this problem. The model describes how a "reputational equilibrium" can result if savers refuse to repatriate their capital for a certain amount of time following a government's decision to renege on its commitment. Another major impediment is the following:

"In a democracy, there is no independent authority to verify to the satisfaction of savers that the realization of the state of the world in fact justifies a capital levy. Even if savers recognize that capital taxation is a contingent claim, they retain the incentive to dispute that the relevant contingency has arisen. Neither is there a mechanism to prevent the government from pursuing policies that strengthen the case for capital taxation -- for example, increasing ordinary expenditures as levy receipts roll in. Savers will accuse the government of succumbing to moral hazard and resist the levy on those grounds... If the levy is imposed at all, typically this will occur only at the end of a protracted and divisive political debate...If there is an extended delay between proposal and implementation of the levy, capital flight is likely to render the measure ineffectual."

In light of these impediments to the successful use of a capital levy, Eichengreen analyzes a number of previous levies, mostly in the aftermath of World War I, and explains why they obtained varying degrees of failure or partially success. His first example, however, is not from post-WWI but rather from the ancient Greeks. They used periodic capital levies of one to four percent which, it is said, were "phenomenally successful because property owners, out of vanity, overstated the value of their assets!" Capital levies were also proposed, but not adopted, following the Napoleonic wars, the Franco-Prussian war, and other periods of major military expenditure. But the end of WWI was the true hey-day of the capital levy.

Italy imposed a capital levy in 1920. The rates ranged from 4.5 to 50 percent; however, payment could be stretched out over 20 years. Thus, it was successful but not too comparable with the Cyprus levy, which would be paid at once. The Czech levy of 1920 is more comparable with the Cyprus levy, and was more successful than levies in Austria, Hungary, and Germany at that time. In Czechoslovakia, a levy on all property was imposed, with progressive rates from 3 to 30 percent, with a separate surtax on the wartime increment up to 40 percent. There are two main reasons this levy was relatively successful. First, the levy fell mainly on a small ethnic German minority, which was unable to mount effective political resistance to delay adoption, so capital flight was minimized. Second, the government budget was structured so that levy revenue was completely separate from day-to-day government operations. The levy was explicitly devoted to extinguishing debts and meeting the special costs of establishing a newly-independent nation. This "lent credibility to claims that the levy was an extraordinary tax whose repetition was unlikely."

Other countries' levies were less successful. In Austria, political delays dragged on so long that asset holders had more than a year to prepare, so capital flight was extensive; moreover, hyperinflation liquidated levy obligations. Similarly, delays in other countries enabled capital flight. In Britain, a levy was long debated but never imposed. Keynes himself weighed in, initially in support of the levy, but later opposing it by the mid twenties, when postwar exceptional circumstances were further in the past.

The Japanese levy after World War II is Eichengreen's example of the exception that proves the rule. It was successful because the typical impediments to success were negated by the exceptional circumstances. Capital flight was limited, and the levy applied primarily to a small minority of individuals considered to have profited greatly from the war. In 1946-47, Japan's sovereignty was severely abridged by occupation forces. Thus "with important elements of democracy in suspension, the levy could be quickly and effectively implemented. One might go further and argue that only when political sovereignty is suspended can the measure be pushed through with such alacrity." Also, since the levy was essentially imposed by outsiders, it did not damage the Japanese government's reputation too much or adversely impact the ability of the Japanese government to raise revenue subsequently.

Lessons for Cyprus

A common theme of levies in the 20th century is that delays, usually politically-induced, cause capital flight and prevent the levy from raising a successful amount of revenue. The Cypriot parliament has already delayed its vote on the deposit levy to Monday. We will see how long the proceedings drag on. In Cyprus,  the levy will fall in large part on foreign depositors, particularly Russians, like the Czech levy fell mainly on Germans. It is not clear whether foreign depositors will prove as unable to mount political resistance in Cyprus as the Germans were in Czechoslovakia.

The levy in Cyprus is progressive, like it was in Czechoslovakia, although not to the same extent. The rate is 6.75% on deposits less than 100,000 euros and 9.9% on larger deposits. According to Eichengreen, a crucially important feature of the successful Japanese levy was the "sociopolitical argument," or the fact that the levy was imposed on people who were seen as having profited unjustly from the war. Engineers of the Cypriot levy may make the case that it is imposed on Russian money launderers or other wealthy depositors funneled their money there for less than admirable reasons. This case might be easier to make if the levy were more progressive-- if it hit bigger accounts harder, and were easier on the small accounts.

The Japanese levy did not adversely impact future Japanese governments' ability to borrow because it was imposed by outsiders. The Cypriot government may also be able to point to the IMF and EU as the masterminds behind this levy. The bigger issue, though, is whether other EU countries will suffer reputational penalties by virtue of association.

Finally, what worked really well for Czechoslovakia was that the levy revenue was totally separated from other tax revenue and dedicated strictly to paying off debt and to the needs of the extraordinary circumstances. It was not used to fund day-to-day operations of the government. That made it seem less likely that the government would be tempted to impose another levy in the near future. That is a feasible option for Cyprus, which they will hopefully employ.

Underneath the Bankers' New Clothes

Anat Admati and Martin Hellwig are the authors of a new book called The Bankers’ New Clothes. This book has been favorably reviewed by John Cochrane and mostly-favorably reviewed by Matthew Yglesias at Slate, though he has a few qualms about it:

Admati and Hellwig say... we should make [banks] fund a much larger share of investment—20 to 30 percent—with equity... Conventional wisdom both in the industry and among the regulatory establishment is that this would be economy-killing madness leading to huge increases in borrowing costs. Brookings Institution fellow Douglas Elliott, in one of the milder critiques, says borrowing costs would rise by about 2 percentage points... The authors’ partially persuasive reply is that this involves confusing social costs with private costs... 

Less convincing is the authors’ claim that imposing stricter capital regulation would have no costs. They analogize their proposal to rules preventing firms from engaging in excessive pollution but fail to explore the analogy deeply enough.

Admati and Hellwig, along with Peter DeMarzo and Paul Pfleiderer, have in fact studied their claim more deeply than they get into in the book. They have two papers from 2010 and 2012 which provide the technical background for the book. We discussed the 2012 paper, "Debt Overhang and Capital Regulation," in the Berkeley macroeconomics reading group this week. I'll try and walk through it here.

High leverage in the banking sector is frequently implicated as a source of systemic risk. After the financial crisis of 2007-2009, regulators sought to require that a greater share of banks' investments be funded by equity. There have been arguments made (including by bankers) that greater equity requirements would be costly to the economy. Admati et al. (2010) argued that this is not the case: the benefits of increased equity financing would be large, while the costs would be small if not negligible. For instance, one common argument is that increased equity requirements would increase banks’ funding costs because equity requires a higher return than debt. Admati et al. say that "This argument is fallacious, because the required return on equity, which includes a risk premium, must decline when more equity is used." The benefits of more increased equity requirements come from the fact that with more equity funding, banks can absorb more losses without becoming distressed, defaulting, requiring government support, or causing a financial crisis.

In their newer 2012 paper, Admati et al. consider the situation in which leverage is already high, and analyze shareholders’ incentives to change the leverage of a firm that already has large debt overhang. Heavy debt overhang incentivizes shareholders to resist reductions in leverage. The reason is that leverage reductions make the remaining debt safer (reduce the default probability), which benefits existing creditors and anyone providing guarantees to the debt, but doesn't benefit shareholders enough to compensate them for the price they have to pay to buy back debt. Shareholder resistance to leverage reduction can persist even if leverage reduction would increase the total value of the bank. This effect is present even without government subsidies of debt (but such subsidies make it worse.) Debt overhang can create an "addiction" to leverage among shareholders. There is a ratchet effect, where shareholders sometimes want to increase leverage, but would never want to reduce it.

Notice, shareholders are resistant to buying back debt because they are not compensated for the ensuing reduction in default probability, which benefits debt holders rather than shareholders. Something that came up during our group discussion of this paper was the fact that, if debt were already perfectly safe (zero default probability), then reductions in leverage would not reduce the default probability, so this effect would not hold. When default probability is quite low, debt buybacks can only reduce the default probability by a small amount, so shareholder resistance to leverage reduction should be relatively small. So from a policy perspective, it makes more sense for recapitalization to be imposed when times are good (when default probability is low), rather than in the midst of a crisis (when default probability is higher.)

The above results come from a model in which a firm has previously made an investment of amount A in risky assets and has funded itself with debt. The total debt claim is D. Investment returns in the future period are a random multiple of A, xA. The payouts of the firm’s securities in the future period depend on taxes, bankruptcy costs, and government subsidies. The firm defaults if xA<D and pays its debt in full otherwise. The payoffs to the shareholders and the debt holders depend on whether or not xA<D. They first consider whether a buyback of debt (pure recapitalization) can be beneficial to shareholders. They find that "Equity holders are strictly worse off issuing securities to recapitalize the firm by repurchasing any class of outstanding debt." This creates an interesting tension:

When default is costly to the firm, the interests of equity holders can be in conflict with maximization of total firm value. For example, if taxes and subsidies are zero while bankruptcy costs are not, then a recapitalization and buyback of risky debt raises the combined wealth of shareholders and debt holders jointly. Yet, shareholders consider such a move harmful to their interests. Thus, debt overhang can give rise to a situation in which shareholders and debt holders jointly would benefit from a recapitalization and debt buyback, but shareholders would not find it in their interest to recapitalize.

In a somewhat random but interesting anecdote in the middle of the paper, they cite the buyback of Bolivian sovereign debt in 1988 as an example of debt buyback benefiting debt holders. Bolivian debt was trading at 6 cents on the dollar, and there was a notion that the international community should buy this debt and forgive it to provide Bolivia with debt relief.  The market price of Bolivian debt after the buyback was 11 cents on the dollar, and debt holders' wealth collectively increased by over $33 million.


In situations where banks are required to reduce their leverage, there are two main alternatives to pure recapitalization. The alternatives prove equally undesirable to shareholders:

A pure recapitalization involves buying (or paying) back debt using new equity funding, without any change in assets. Alternatively, the ratio of equity to assets can be increased by selling assets and using the proceeds to buy back debt, a process often referred to as “deleveraging.” Finally, the firm may increase the equity to asset ratio by issuing new equity and acquiring new assets. 

We obtain a striking “irrelevance” result: If there is one class of debt outstanding and asset sales or purchases do not, by themselves, generate value, then shareholders are indifferent between asset sales, pure recapitalization and asset expansion. All are equally undesirable from the perspective of shareholders.

If, however, there are multiple asset classes, shareholders prefer asset sales over recapitalization or asset expansion, because all debt is the same to the shareholders, and junior debt is cheaper:

This also may explain why shareholders would choose to engage in asset sales or “deleveraging” (as opposed to recapitalization or asset expansion) if a decrease in leverage is imposed by regulation and there are no covenants protecting senior debt holders. In this case, if the proceeds of a sale of assets are used to buy back junior debt and perhaps make payouts to equity, the senior debt holders lose to the benefit of the shareholders. Shareholders therefore prefer this over a pure recapitalization or asset expansion.

What determines a firm's ex ante decision about debt and equity financing?  By Modigliani and Miller (1958), the capital structure choice is only relevant to the ex ante value of the firm to the extent that it is affected by frictions including taxes, bankruptcy costs, bailout subsidies, and agency costs. If these frictions change, the effect on capital structure is asymmetrical. One interesting policy implication is:

The total value of banks, net of the value of bailout subsidies, can be increased when regulators force banks to recapitalize because, in effect, the regulators can create a commitment technology that allows banks to overcome the debt overhang agency problem that would otherwise prevent beneficial recapitalizations. In other words, assuming there are no bailout subsidies but there are bankruptcy costs (that are incurred by the firm), regulators who force the firm to recapitalize might enhance its ex ante value by allowing it to raise debt at a lower price than it could absent a way to commit to such recapitalizations.

However, as far as I can tell, the model does not help us understand what level of recapitalization is ideal. Does recapitalization monotonically increase the ex ante value of the firm, all the way up to 100 percent equity? The model tells us that higher equity is better, but does not tell us how high is optimal. So I don't know where the 20 to 30 percent recommendation comes from. The model is two-period. It would be hard, but interesting, to think about longer horizons. Another important point is that the result about shareholders resisting recapitalization holds even in a stripped-down model with no taxes, subsidies, or bankruptcy costs. The taxes, subsidies, and bankruptcy costs can exacerbate the result but do not drive it. It would be interesting to see some analysis of how much they are exacerbating the problem.

The Financial Sector after the Crisis

When Italian Prime Minister Silvio Berlusconi announced Ignazio Visco as his pick for Governor of the Bank of Italy in October 2011, it came as something of a surprise. Berlusconi was under pressure from various ministers to pick their candidates for Governor, but he ended up picking none of their choices and going with Visco. Visco was the third-ranked official at the Bank of Italy before he replaced Mario Draghi when Draghi became President of the European Central Bank. Visco did his PhD at Penn and was chief economist at the Organization for Economic Cooperation and Development from 1997 to 2002.

Based on a lecture he gave in London earlier this month, Visco seems to be a wise choice. Visco's lecture, titled "The Financial Sector after the Crisis," is epically ambitious. The first section of the lecture is called "'Good' finance as a force for good." He is heavily influenced by Amartya Sen, whom he quotes multiple times. The first Sen quote, referring to finance, asks "How is it possible that an activity that is so useful has been viewed as being morally so dubious?" It is apparent that Visco has reflected on this question quite a lot:

One can detect cyclical patterns in the public’s attitude towards finance, affected by the conditions of financial systems and shifts in the political mood about state intervention in the economy. Until the 1970s it was taken for granted that market failures required the presence and response of a regulator to avoid suboptimal results. Then came the great inflation of the 1970s, combined with high unemployment, and the emphasis shifted to government failures. Governments, central banks and other regulators were blamed for failing to prevent these developments. This eventually led to an ideological swing: a push to reduce the extent of state intervention. The failures of the “regulated economy,” the pace of technological advance and the rapid expansion of international trade after the end of the Cold War fuelled a protracted process of financial deregulation that was halted only by the financial crisis that broke out in 2007. The latter triggered a move toward re-regulation – or better regulation – that is still under way. The pendulum keeps swinging and will certainly continue to do so. 

The global financial crisis, with its huge costs for the whole society, has caused a further deep erosion of the trust in financial institutions. Witness to this are the widespread protests against the financial industry, from the Occupy Wall Street movement to the “Indignados” in Spain and their counterparts in other European countries. Anger has been fuelled not only by the discovery of wrongdoings and perverse incentives, but also by a perceived lack of action against those responsible, in a context of exceptionally high remunerations. The integrity of financial intermediaries’ codes of conduct has been called into question under many dimensions: honesty, the ability to manage financial risks and the commitment to take care of the interests of their clients.

He also quotes Sen as saying that “finance plays an important part in the prosperity and well-being of nations.” He takes a long historical perspective on financial innovation, from the “letters of exchange” introduced by Italian merchants in the Middle Ages to today's structured finance products and originate-to-distribute intermediation model.

He recognizes that both the distrust of finance and its role in prosperity come from its complexity. He praises financial literacy efforts as a way to alleviate some of the public distrust of finance, but cautions that "as the case of Bernard Madoff and others in the US and elsewhere clearly show – this is no panacea (Madoff’s customers were surely much better educated than average). Therefore, for purposes of consumer protection in the financial services industry, financial regulation and good supervision are the necessary complements to financial education and inclusion." When it comes to regulation, however, he believes that "Complexity was also used, somewhat perversely, as an argument in favour of a sort of benign neglect on the part of regulators."

The big financial players argued successfully that financial innovation was too complex and too opaque for the regulators to get their heads around. Indeed, they said, to safeguard the international financial system from systemic risk, the main priority was promoting an “industry-led” effort to improve internal risk management and related systems. This, in a nutshell, was the view espoused by the Group of Thirty report following the outbreak of the Asian crisis. But this thesis was often accompanied by the argument to the effect that “you, regulators and supervisors, will always be behind financial innovation; it would be better to allow us, the big financial international players, to self regulate; we are grown-ups, we can take care of ourselves...” 

The difficulties in coordinating the regulators’ actions, in the face of a natural tendency to preserve each one’s particular sphere of influence, was a powerful drag on the ability to rise to the challenge posed by a finance gone global... The phenomenon of regulatory capture was a definite reality...Financial regulation and supervision have to keep pace with developments in the financial industry... The coordination of financial supervision across borders and across sectors is a key condition for the stability of the global financial system. More importantly, regulators and supervisors have to pay attention to keeping financial industry lobbies at due distance.

The next section of the lecture, "In search of a better regulatory and supervisory regime," is worth reading for a summary of recent reforms by the Basel Committee on Banking Supervision. But more interesting and surprising is the subsequent section of the lecture, "Observations on the analytical implications of economic and financial instability."  He describes, with more lucidity and in fewer words than I have heard before, the challenges of "non-ergodicity."

Changes in institutional arrangements, technological innovation and revisions in economic policy paradigms continuously reshape the framework in which economic agents (consumers and businesses) make their decisions...When there is marked discontinuity with the past, such changes may be far-reaching and the past fails to provide enough guidance for the present (never mind the future). We should always remember that the financial system is part of a richer social, economic and political environment... 

However, a stationarity assumption of sorts underpins our theoretical and statistical models, in the case of economic forecasting and (macro) policy making as well as in the case of financial analysis and risk management. In general, the basic tenet is that future outcomes will be drawn from the same population that generated past outcomes, so that the time average of future outcomes cannot be persistently different from averages calculated from past observations and future events can be predicted with a certain degree of statistical accuracy. In non-ergodic environments, on the contrary, at least some economic processes are such that expectations based on past probability distribution functions can differ persistently from the time averages that will be generated as the future unfolds.

In case of acute uncertainty, no analysis of past data can provide reliable signals regarding future prospects. The challenges posed by the non-ergodic nature of economic systems may be met by recognizing that our models are by necessity “local” approximations of very complex economic and financial developments.

In the above paragraphs he cites a 1991 paper by Paul Davidson, “Is probability theory relevant for uncertainty? A Post Keynesian perspective." He also cites Charles Kindleberger: “For historians each event is unique. Economics, however, maintains that forces in society and nature behave in repetitive ways.” In conclusion, he adds:

This is not to say that all the analytical efforts of the past and the progress achieved should be disregarded. It means rather that in order to make the best out of them one needs to remember that models are by necessity “local” approximations to very complex phenomena and they should be used with good sense as a framework, not a straightjacket, for our decision-making. Quantitative analysis and modelling can also help to establish institutional and behavioural norms to rein in patterns of instability and developing proper learning devices to deal with major shocks and regime changes. In turn, models should take into account the impact of such norms on economic developments.  

Krugman and Plosser on Deleveraging

On March 6, 2013, Philadelphia Fed President Charles Plosser argued that low interest rates are actually causing people to save more, not less, because the income effect currently outweighs the substitution effect. In his words:

The conventional view is that by lowering interest rates, monetary accommodation tends to encourage households to reduce savings and thus consume more today. However, as I’ve noted, in the current circumstances, consumers have strong incentives to save. They are deleveraging and trying to restore the health of their balance sheets so they will be able to retire or put their children through college. They are behaving wisely and in a perfectly rational and prudent way in the face of the reduction in wealth.

In fact, low interest rates and fiscal stimulus spending that leads to larger government budget deficits may be designed to stimulate aggregate demand or consumption, but they could actually do the opposite. For example, low interest rates encourage households to save even more because the return on their savings is very small. And large budget deficits suggest to households that they are likely to face higher taxes in the future, which also encourages more saving. In my view, until household balance sheets are restored to a level that consumers and households are comfortable with, consumption will remain sluggish. Attempts to increase economic “stimulus” may not help speed up the process and may actually prolong it.

This reminds me of an article by Paul Krugman last year called Deleveraging Shocks and the Multiplier (Sort of Wonkish).

So, the simple but surely broadly correct story of the mess we’re in is that we had a period of excessive complacency about leverage, which came to a sudden end. Household debt in particular surged, then was suddenly perceived as excessive...

Leveraging up, other things equal, leads to high aggregate demand — but this can be and is in practice offset by the central bank, which can always raise rates. Deleveraging, on the other hand, can’t be offset equally easily; the central bank can cut rates, but only to zero, and unconventional monetary policy is both controversial and an iffy proposition (which doesn’t mean that it shouldn’t be tried).

So far, Plosser and Krugman more or less agree. Households are deleveraging because they really want to deleverage, we're at the zero lower bound, and unconventional monetary policy is iffy. (As Plosser puts it, "We are operating in an uncertain environment and using nontraditional policies with which we have limited experience.")

Here's where the big, big difference comes in. Plosser also said that fiscal stimulus wouldn't work in this scenario because "large budget deficits suggest to households that they are likely to face higher taxes in the future, which also encourages more saving." Let's break this down.

An increase in the deficit raises both current income and expected future taxes. If the government spending multiplier is one, an increase in the deficit is neutral for consumption. So people consume the same amount they otherwise would have, and save the additional income to use to pay future taxes.Yes, large deficits encourage more saving, but without reducing consumption. In other words, they increase the total level of savings people have, but they decrease the rate of saving out of current income. The rate versus level distinction is important. If households follow some heuristic about a minimum theshold level of saving they want to achieve (e.g. make sure to have $5,000 saved in case of emergency), then they could reach that threshold quicker (and stop deleveraging) through fiscal stimulus. And that is just assuming the multiplier is one. Even better if it is larger...which of course brings us back to Krugman:

Now, the same thing that makes deleveraging so hard to handle also makes the fiscal multiplier larger than it is in normal times. Normally, expansionary fiscal policy is offset by monetary tightening, contractionary policy by monetary loosening. Hence the lowish multiplier estimates based on recent history. But if deleveraging has pushed you into a liquidity trap, there are no offsets...Start by provisionally assuming a frictionless world in which consumers have perfect foresight and perfect access to capital markets. In that case the multiplier should be exactly 1...A rise in government spending does mean higher expected future taxes — but it also means higher incomes right now, and those two effects should exactly cancel each other.

Now add in realistic frictions, notably households that are liquidity-constrained and/or use rules of thumb based on current income to make spending decisions. (By the way, as Gauti Eggertsson and I have pointed out, once you’re using a debt/deleveraging model you are already in effect assuming that many households face liquidity constraints). These frictions will mean that a rise or fall in current income due to fiscal policy will lead to at least some movement of consumption in the same direction. So we get a multiplier bigger than 1.

But I would add that this is not just a question of whether the multiplier is bigger than one. Whether or not the multiplier is bigger than one, in fact just as long as it is bigger than zero, fiscal policy will at least help people reach their level-of-savings targets quicker, if that is the way some people decide how much to save (which seems intuitively reasonable.) Unfortunately, as Meryl Motika pointed out in her post yesterday, we don't know enough yet about how people decide to save. And that's getting to be a highly pressing issue for both monetary and fiscal policy.

Guest Post: Information and Planning in Saving Decisions

I am pleased to present this guest contribution by Meryl Motika, an economics job market candidate at UC Irvine. She describes a cleverly-designed laboratory experiment about the factors that influence people's decisions about spending and saving.

Economists have an elegant model of how people might save called the Life Cycle Hypothesis. The basic idea is that people want to maintain a consistent standard of living over time. According to this model, we should see people go into debt when they are young, pay off their debts and save as their wages rise, and retire with enough wealth to maintain their lifestyle until they die.

The Life Cycle Hypothesis seems to fit some people’s behavior pretty well. However, a significant portion of the population either saves much more than they need or fails to save even during their prime earning years. For these individuals, consumption (how much money they spend) tends to go up and down with current income instead of being smoothed over the life cycle.

A fascinating paper by Erik Hurst called Grasshoppers, Ants and Pre-Retirement Wealth: A Test of Permanent Income Consumers shows that the same individuals who fail to save enough to cover temporary layoffs also fail to save enough for retirement. It’s tempting to imagine that they just don’t earn enough to save, but in practice it’s not so easily explained. At any given income level, some people seem to follow the Life Cycle Hypothesis model while others save too much or don’t save.

So why do some people save while others don’t? A number of reasons have been suggested including that people tend to do blindly whatever is suggested to them, failures to plan ahead, differences in thinking about the future, ability to resist temptation, and differences in financial knowledge. There is evidence in favor of each of these explanations. However, they are difficult to study because it’s hard to get good information about wealth, income, probable future income, life expectancy, and other factors in saving decisions. Worse, someone who saves a lot might also get a job with a good retirement plan, resist temptation, and learn about finance just because they’re that type of person.

I decided to take this puzzle to the laboratory and designed an experiment in which subjects decide whether to “spend” or “save” tokens to watch video clips. Since the alternative is looking at a still screen, boredom provides a strong incentive to spend the tokens early. The incentive to save is that the video clips are longer towards the end of the experiment; savers get to watch more video. The great thing about this design is that it is very open-ended. I observe actual spending decisions made over a span of time, without any particular decision being obviously “correct.”

In my paper Information and Planning in Saving Decisions, I find that even in a very short (50 minute) session subjects make various saving choices; some watch all their videos immediately, some save for the end of the session, and some spread the videos out over the session. I was also able to examine the effects of “financial information” (extra instructions with examples and screenshots to make people more comfortable with their options) and being asked to plan ahead. In my experiment, information causes many subjects to save rather than watching the videos immediately. Planning ahead appears to make subjects more likely to smooth their vide-watching over the session, although this point requires further testing.

What can we learn from this? First, under-saving isn’t all about being susceptible to temptation. How the saving problem is presented affects subjects’ decisions even though the temptation to watch videos early is always the same. Second, I was able to induce something like normal saving behavior in the laboratory, meaning that saving decisions can be studied in a laboratory setting. This opens doors for future research into the effects of risk, life expectancy, learning from others, and so on. Validation of my results through replication (especially in sessions spread over several weeks) and examining the relationships between laboratory behavior and actual saving behavior must come first, though!

Bernanke, Bankers, Bubbles

In 1999, at the height of the dot-com bubble, Ben Bernanke and Mark Gertler argued emphatically against central banks responding to movements in asset prices.  Monetary policy could react to the macroeconomic consequences of asset price movements, but not to asset prices themselves. In other words, monetary policymakers should not raise interest rates solely to address a potential bubble.

After the dot-com bubble burst, they held firm in their opinion in a 2001 paper titled "Should Central Banks Respond to Movements in Asset Prices?" Their answer to the title question is a firm no. They build and simulate a model of the economy that includes both technology shocks and "stock price bubble" shocks and find that "an aggressive inflation-targeting rule stabilizes both output and inflation when asset prices are volatile, whether the volatility is due to bubbles or to technological shocks; and that, given an aggressive response to inflation, there is no significant additional benefit to responding to asset prices."

The housing bubble prompted a number of challenges to the Bernanke-Gertler dictum. A fairly common view is that expansionary monetary policy contributed to the housing bubble. Dean Baker and John Taylor have both argued that the housing bubble was caused by the Fed keeping interest rates too low for too long. (In 2001 the Federal Funds Target rate was lowered from 6.5 to 1.75 percent. In 2003 it was lowered to 1 percent and held there for a year.) Bernanke counters that increased use of variable-rate and interest-only mortgages and the decline of underwriting standards were more to blame than low interest rates.

Now, interest rates are again very low, and have been for quite some time. Challenges to the Bernanke-Gertler view are more vociferous than ever, and come not only from John Taylor but also from Chairman Bernanke's committee members and his contemporaries at other central banks. Fed Governor James Bullard, for example, says that "maybe you should think about using interest rates to fight financial excess a little more than we have in the last few years.” Kansas City Fed President Esther George and Fed Governor Jeremy Stein express similar views that the Fed should use its control of interest rates to do something about "overheating." However, Fed Vice Chairwoman Janet Yellen shares Bernanke's view that the benefits of accomodative monetary policy at this point outweigh the risks of any potential financial overheating.

When Bernanke wrote his 1999 and 2001 papers with Gertler, he was a professor at Princeton University. Another Princeton professor, Lars Svensson, is the Deputy Governor of the Swedish Riksbank. At the Riksbank last month, Governor Stefan Ingves warned that low interest rates are driving up household debt. But Svensson is a strong proponent of his former colleague's views. At the February Rikbank meeting, he argued against the committee's concerns that low interest rates could be leading to financial instability. He cites a 2012 paper by Kenneth Kuttner called "Low Interest Rates and Housing Bubbles: Still no Smoking Gun," whose title summarizes its conclusion.  In particular, Kuttner estimates that a 25 basis point expansionary monetary policy shock raises house prices by about 0.3% to 0.9%, which is "too small to explain the previous decade's real estate boom in the U.S. and elsewhere... Credit conditions, broadly defined, may play a larger role in house price booms than interest rates per se. In market-oriented financial systems, like that of the U.S., a loosening of credit conditions plausibly resulted from financial innovation, such as securitization, and a relaxation of lending standards."

Svensson's long list of publications and speeches reveals a longstanding interest in monetary policy and financial stability, with views consistently in accord with Bernanke's. In a 2011 lecture called "Central-Banking Challenges for the Riksbank: Monetary Policy, Financial-Stability Policy, and Asset Management" Svensson notes:

"Monetary policy and financial-stability policy are distinct policies, with different objectives, different instruments, and different public authorities having responsibility for them... Monetary policy should be conducted taking the conduct of financial-stability policy into account, and vice-versa. But they should not be confused with one another. Confusion risks leading to a poorer outcome for both policies and makes it more difficult to hold the policymakers accountable."

One of the most interesting blog posts I have read on this topic is from Miles Kimball, who writes that people taking on more risk as a result of low interest rates is "a genuine cost to the Fed stimulating the economy with low interest rates. But— especially once we figure out the details—it has much bigger implications for financial regulation than for monetary policy...Regulation has serious costs, but so does tight monetary policy in the current environment." This seems to be the view of Bernanke, Yellen, and Svensson, but is still far from a settled issue among the world's monetary policymakers.